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Question: My client’s spouse is the owner of an insurance policy on the client’s life. They want to remove the death benefit from both spouses’ taxable estates. If the policy is transferred to an irrevocable trust (ILIT), does the three year inclusion rule apply?
Answer: Probably not, although the specific circumstances might cause either a three year problem or a permanent estate tax problem.
Revenue Code Sections 2035 and 2042, read together, say that when the insured under a life policy makes a gift transfer of that policy—or a gift transfer of incidents of ownership—for three years after the transfer, the insurance death benefit is still includible in the insured’s taxable estate.
Where someone other than the insured owns the policy and makes the transfer, the three year rule does not apply. Using just that analysis, it would seem that having the spouse make the transfer of the insurance on the insured’s life to an ILIT would avoid tax problems. However, that’s not the end of the analysis.
If it can be successfully argued by the IRS that the insured had incidents of ownership in the life contract due to the marriage relationship with the policy owner spouse, then the three year problem might still exist. The insured spouse might be imputed ownership, for example, through community property rules in the state of the spouses’ residence. Even in non-community property states, it’s possible the IRS could argue that the insured spouse has a property right in the life policy due to the marriage.
In addition to the potential for the three year problem in the example above, there’s another issue if the policy owner spouse is a beneficiary of the ILIT. If that’s the case, the value of the ILIT—including the value of the life policy or its death benefit—would be included in the taxable estate of the non-insured spouse at death. The authority for that would be from the rules under Revenue Code Section 2036, which subjects lifetime transfers with a retained interest to estate taxes.
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